Homebuilders Have Already Had Their Recession

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Includes: BZH, CCS, DHI, FPH, HOML, HOMZ, ITB, KBH, LEN, MDC, MHO, MTH, NAIL, NVR, PHM, PKB, TMHC, TPH, WLH, XHB
by: Hoya Capital Real Estate
Summary

Amid the volatile backdrop of trade wars and geopolitical uncertainty, the US housing market may be an unlikely stabilizing force. As goes the housing sector, so goes the economy.

2019 continues to be a year of rejuvenation for the single-family homebuilders after falling into a “mini-recession” in 2018. Sharply lower mortgage rates have eased affordability concerns.

Second-quarter earnings season may go down as the turning point for the largest US homebuilders. Order growth exceeded expectations, rising more than 6% from last year.

While slower-reacting data sets remain soft, forward-looking metrics like mortgage demand, homebuilder sentiment, and commentary from homebuilders have painted a brighter picture for the second half of 2019.

Long-term fundamentals continue to support healthy and growing demand for single-family homes in the 2020s and upward pressure on home values amid a growing housing shortage.

Homebuilder Rankings Overview

In our Real Estate Rankings series, we analyze each of the commercial and residential real estate sectors. We analyze homebuilders based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these reports every quarter with new developments.

homebuilder rankings 2019

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Homebuilding Sector Overview

The US single-family homebuilding sector is a highly cyclical, competitive, and fragmented industry. The top ten largest builders account for roughly a quarter of the total new home sales, but this concentration has intensified since the recession in a trend we've described as "Go Big or Go Home" due to the challenging economics of homebuilding, a business where net margins are typically in the single-digits even in the best of times. New home construction has been slow to recover since plunging during the recession, and by nearly every metric, the US has been significantly under-building homes - particularly single-family homes - over the last decade.

homebuilding 2019 In the Hoya Capital Homebuilder Index, we track the ten largest homebuilders, which account for roughly $70 billion in market value: D.R. Horton (DHI), Lennar (LEN), NVR (NVR), PulteGroup (PHM), KB Home (KBH), Taylor Morrison (TMHC), MDC Holdings (MDC), Meritage Home (MTH), and TRI Pointe (TPH). Smaller single-family builders outside of our index include M/I Home (MHO), Century Communities (CCS), William Lyon Homes (WLH), Five Point (FPH), and Beazer Homes (BZH).

homebuilders

While single-family homebuilding ETFs (XHB and ITB) are sometimes viewed as a proxy for the entire US housing market, single-family builders account for only about 15% of the Hoya Capital US Housing Index, which tracks the GDP-weighted performance of the US Housing Industry. While a small number of single-family builders including Lennar have made investments towards multifamily development in recent years, these builders remain almost exclusively single-family builders. Including the home building products and materials category which also supplies to the relatively faster growing multifamily sector, we estimate that annual spending on home building and construction accounts for around 30% of total spending on housing and housing-related services at roughly $1 trillion in 2018.

HOMZ

Homebuilding segments can be roughly split into four categories: entry-level, move-up, luxury, and retirement. As construction and regulatory costs have risen further over the past decade, homebuilders have shifted their focus towards higher-end units which command high enough margins to offset these increased costs, though we've seen a recent trend over the past year towards lower-value construction in cheaper markets. According to the Census Bureau, the median new home price was for a newly-built home was $310,400 in June, which was flat on a year-over-year basis. These ten single-family homebuilders, however, skew towards the higher-end segments with an average selling price of $415,000 in 2Q19, which was down 2% year-over-year.

selling price homes

Homebuilding is really two distinct businesses, each with different risk/return characteristics: 1) Land Development; and 2) Home Construction. Historically, homebuilders have been overweight in the land development business, holding hundreds of millions of dollars worth of unused land on their balance sheet and going through the multi-year permitting to get the land ready for single-family development. Large builders have increased their use of land options since the financial crisis, allowing these firms to focus on construction rather than permitting. This reduces risk and increases return on equity, but typically comes at the expense of lower margins.

homebuilders 101

For homebuilders, it's all about the "5 Ls": lending, lumber, labor, land, and legislation and in 2018, all five of these factors were stiff headwinds. Most notably, for lending, higher mortgage rates pushed affordability to cycle-lows while lumber, labor, and land costs were all significantly higher throughout the year. Legislation - through tax reform and the continued challenges on the zoning and permitting front - may have been the most significant headwind of all given the reduction in homeownership incentives associated with doubling the standard deduction and the State and Local Tax (SALT) deduction cap. These headwinds ultimately resulted in a "mini-housing-recession" in which new home sales, existing home sales, housing starts, and housing permits all turned lower on a year-over-year basis for the first time since 2008 and these homebuilding stocks themselves were off by an average of 30% last year.

These clear signs of softness in the single-family markets prompted calls from the financial media and analysts - which has long been bearish on the single-family housing sector- of “peak housing” and an end to the post-recession housing recovery. If indeed this was the end, it would come at a time when total housing starts remain than 20% below the 1970-2000 average and more than 40% below those levels on a population-adjusted basis. It would also come ahead of an impending demographic-driven boom of millennials, who are just now entering the housing markets led by the largest age cohort in America, the 25-30-year-olds, who are 1.5 million people stronger than the prior five-year age cohort.

housing demographics

Signs of Strength for Homebuilders

Second-quarter earnings season may go down as the turning point for homebuilders following perhaps the worst quarter for the sector since the financial crisis in 1Q19. The most closely-watched metric, order growth, significantly exceeded expectations, rising more than 6% from last year, suggesting that lower mortgage rates are indeed translating into improved demand. The strength was most pronounced, interestingly, in the smaller homebuilders as Taylor Morrison, MDC, and Meritage each reported order growth of more than 20%. Homebuilding revenues, meanwhile, grew 4% while deliveries rose 5%. Commentary on earnings calls was decidedly positive with most builders noting momentum continuing in the weeks since quarter-end.

homebuilder ETFs

Homebuilding margins, while weaker on a year-over-year basis, were generally in-line or slightly ahead of estimates. Last year, homebuilders were hit by the double-whammy of weak demand and rising cost pressures that sent operating margins plunging in late 2018. Still feeling the effects of the 2018 mini-recession, operating margins for the five largest builders declined an average of 62 basis points while margins for the next five largest builders declined 90 basis points. With a high degree of operating leverage, order growth should translate into improved margins in the second half of 2019.

homebuilders marigns It's "Go Big or Go Home" for the homebuilding sector as we continue to note the bifurcation between the larger and smaller homebuilders. Even within our coverage, which only includes the largest ten builders in the country out of a pool of more than 20,000 total single-family builders, the critical importance of scale becomes clear through the wide gap in operating margins, which declines linearly with size. It's reasonable to assume, given the linear trend in the data as well as anecdotal and survey data, that very small private builders are having a very difficult time breaking-even on single-family development projects given these tough economics. As a result, we believe that an increasing share of starts will accrue to the publicly traded homebuilders with the scale necessary to achieve an adequate return.homebuilder operating margins

The combination of a reacceleration in economic growth, trade disputes, and immigration policy pushed construction costs higher by more than 6% in 2018. While land prices and labor costs continue to rise above the rate of inflation, two of the five Ls - lending and lumber - have eased considerably over the last two quarters. Lumber prices plunged more than 40% since peaking in May 2018 while mortgage rates pulled back considerably, as we'll analyze in more detail below. Labor costs, however, continue to tick higher as tighter immigration policies may put further pressure on the lingering worker shortage. Total costs, however, are higher by just over 2% on a year-over-year basis, the slowest rate of cost growth since 2015, which is very good news for homebuilders.

construction costs 2019

As we've discussed in other reports, home price gains in the pre-bubble period occurred despite modest rises in construction and replacement costs. In one of our favorite charts below, we chart home price appreciation against the US Census Bureau's construction cost index for single-family homes. We see that from 1999 through 2006, home price appreciation more than doubled the rate of construction cost inflation, producing an unstable environment whereby homes were priced far above replacement costs. Since 2007, construction cost inflation has more than doubled the rate of home price appreciation. While a negative for homebuilders, who have less wiggle room to pass on rising costs to buyers, it does indicate that overall home prices are on more solid footing than they were in the "bubble" period.

construction costs to build

Recent Housing Market Data

As we've been discussing for the past several months, the forward-looking metrics in the housing market suggest a solid recovery in home sales data throughout 2019 if post-recession correlations hold, and we're finally beginning to see this strength show up in the slower-reacting data sets like new and existing home sales. Mortgage rates are now lower by more than 75 basis points on a year-over-year basis and 120 basis points since peaking in November 2018, a sharp reversal from the 100 basis point headwind that slowed the housing market in 2018. The MBA Purchase Index, a useful leading indicator of new and existing home sales, earlier this year jumped to the highest level since 2010 while the MBA Refinance Index remains near the highest level since last spring.

housing market data

Mortgage rates have shown a rather remarkable correlation with new home sales during the post-recession period. We continue to believe that 2018/2019 looks quite a bit like 2014/2015 when home sales ground to a halt following the taper-tantrum-led interest rate surge only to surge more than 15% the following year as mortgage rates reversed. While we do think that the lingering effects of tax reform will negate some of the positive flow-through from lower mortgage rates and lead to a lower equilibrium homeownership rate, we would be surprised if new home sales did not accelerate back to the mid-single-digit growth rates by late 2019 if mortgage rates remain around these levels.

mortgage rates home sales

Another forward-looking metric showing upside, homebuilder sentiment has improved since bottoming last December. Homebuilder sentiment dipped late last year to the lowest level since 2015, but since then, lower mortgage rates, continued strength in the labor markets, and moderating construction costs have brightened the outlook for single-family construction this year. All three index subcomponents improved from last month with buyer traffic near the highest level since last July at 48. The South and West remain the strongest regions while the Northeast and Midwest remain relatively soft. Rising homebuilder sentiment data suggest that single-family housing starts should recover in 2019 based on past correlations between the data sets.

homebuilder sentiment

The slower-reacting data, however, continues to reflect the slowing conditions of late 2018. New and Existing Home Sales data for June both came in shy of estimates. Existing sales data generally reflects selling conditions two months prior while new home sales are a bit more timely. New home sales jumped 4.5% over the same time last year on a SAAR-basis while existing sales dipped 2.2%. Pending home sales, released last week, turned higher on a year-over-year basis for the first time in seventeen months.

new existing home sales 2019

Home price appreciation also slowed meaningfully in late 2018 and soft conditions will continue to be reflected in this slower-reacting data for several more months at least. The Case-Shiller Index, released last week, showed that national home prices rose at the slowest rate in nearly seven years at 3.5%. It's important to note that this index is calculated using a three-month average and released with a two-month lag, meaning that newly-released data is still reflecting conditions from early 2019. We think that homebuyers appear to have a short window of opportunity where seller's pricing expectations have trended lower as headlines reflect this "stale" home price data, as we expect pricing to stabilize and perhaps reaccelerate by late 2019 given recent mortgage market conditions.

home prices

We find that investors tend to overweight local market conditions and anecdotal evidence of particularly weak or strong real estate conditions, while often overlooking the wealth of available national data. As always, it's important to remind investors that the US housing market is enormously large and heterogeneous and each of the 120 million housing units in the United States is independently affected by a different set of local economic conditions, illustrated by the nearly 20% spread between the best and worst-performing regional markets.

home prices

In the market-level home price data and the new home sales regional data below, we note the divergence between the weak-performing coastal markets and the better-performing sunbelt markets. Feeling the effects of tax reform and the cap on SALT deductions, home sales in the relatively high-tax Northeast and West Census regions continue to lag the national averages. Seemingly taxed into oblivion over the last several decades, the Northeast region now accounts for less than 5% of total new home sales while the South Census region accounts for more than 50% of new home sales. Over this time, the Northeast has generally been the most challenging region for developers to build due to restrictive zoning and a more hostile regulatory regime. Demographics are especially weak in the northeast markets where boomers outnumber millennials by nearly 20%, adding extra headwinds on home values and home sales over the next decade.

new home sales

Bull and Bear Case for Homebuilders

The winds have shifted rather dramatically over the last seven months as many of the headwinds faced by the homebuilding sector have become favorable tailwinds. A central theme that we continue to discuss is the lingering underinvestment in new home construction during the post-recession period and the ripple-effects it has on all segments of the US housing industry. By nearly every metric, single-family housing markets remain significantly undersupplied. With the exception of the three "bubble" years from 2003-2006, the United States has been under-building homes since the early 1990s, and that trend of underbuilding has intensified dramatically since the housing bubble burst in 2008. A shortage primarily rooted in sub-optimal public policy at the local, regional, and national levels, the US is building homes at a rate that is less than 50% of the post-1960 average after adjusting for population growth.

Household formations outpaced new housing starts by more than 100k in 2018 as the vacancy rate for both owner-occupied and renter-occupied homes reached multi-decade lows in the fourth quarter. More importantly, demographics suggest a significant increase in demand for single-family housing based on historical trends of homeownership preference. The average age of a first-time homebuyer is 32 years old, a cohort that will grow by more than 1.5% per year through 2025 as the largest five-year age cohort in America (born 1989-1993) enters prime single-family homebuying age.

household formations

If affordability - or lack thereof - is the primary headwind for homebuilders, there may be good news. The presence of institutional single-family rental operators has supported demand for affordable "built-for-rent" homes. Consistent with our view that the "institutionalization" of the single-family housing sector is a trend in the early innings, which we discuss in our report on the single family rental REIT sector, we expect built-to-rent buyers to account for a growing percentage of new home sales and single family housing starts over the next decade, giving these builders a sales avenue even if individual homebuyers continue to have affordability difficulties.

housing starts built to rent

Unaffordability issues have been temporarily allayed by the plunge in mortgage rates. While the lagging housing data metrics continue to reflect the slowing conditions of late 2018, forward-looking metrics have turned very favorable over the last several months and we believe housing data will strengthen throughout 2019 if mortgage rates remain at these levels. Further, a significant factor in this sustained undersupply has been the downright dismal economics of new home construction for all but the most operationally-efficient homebuilders. Homebuilding operating margins average barely 10% for the largest builders and decrease to under 5% for the typical small private builder. For that reason, size and scale have become a critical competitive advantage for large homebuilders and we think that market share gains will continue to accrue to the most operationally-efficient builders.

bullish homebuilders

While there are reasons to be bullish on the homebuilding sector, there are also nearly as many reasons to be cautious. On the front-lines of the housing crisis, the homebuilder ETFs (XHB and ITB) plunged more than 80% from peak-to-trough and these funds actually remain below the levels they began trading at when they launched in 2006. A cataclysmic event on many levels, the housing crisis resulted in the end-of-operation for more than 30,000 small private builders and the aftermath of the housing crisis is still being felt across the sector.

housing crisis

While the building industry is still recovering from the crisis, home prices have more than climbed back since the depths of the recession (at least on a nominal basis), prompting renewed worries about housing affordability. Home prices have outpaced personal income per capita growth by nearly 3% per year since home prices bottomed in 2013, aided by historically-low mortgage rates in the post-recession period. Likely rising at above-trend-levels, home price appreciation began to moderate in 2018 amid a steady rise in mortgage rates that significantly slowed the single-family markets. Unaffordability issues, however, have been temporarily allayed by the plunge in mortgage rates.prices incomes rents

Rapidly rising construction costs last year further pressured the already razor-thin operating margins for homebuilders and the effects of these higher costs have lingered into 2019. The 2017 tax reform also removed key tax code incentives to homeownership by capping the state and local tax deductions and raising the standard deduction. These changes have led to significant softness in the high-tax and high-cost coastal markets in particular and we think may result in a lower long-run equilibrium homeownership rate. Further, whether fundamentally justified or not, homebuilder valuations have become increasingly more interest-rate-sensitive in recent years. Below, we discuss five reasons that investors are bearish on the homebuilding sector.

bearish homebuilders

Recent Homebuilder Stock Performance

Homebuilders already had their "bear market" as the sector had its back against the wall in 2018 as a myriad of headwinds looked certain to derail the grinding post-recession recovery, sending the sector lower by 30% last year. Powered by the sharp reversal in mortgage rates, the continued strength in household formations, and the retreat in lumber prices, homebuilders have led the broader equity market rally this year, jumping more than 30%, the best-performing housing sector in the Hoya Capital US Housing Index, an index that tracks the performance of the broader US residential housing industry.

At the company-level, one of the notable trends this year has been the outperformance of the smaller homebuilders and the underperformance of the high-end-focused homebuilders. The three homebuilders with the highest-priced homes, Toll Brothers, TRI Pointe, and MDC have been the laggards so far this year as high-end home values are seeing steeper declines across many markets due to the effects of tax reform, notably the removal of the state and local tax deductions. Meritage and Taylor Morrison have been the best performers, jumping by 69% and 39%, respectively.

Bottom Line: Homebuilders Have Had Their Recession

Amid the volatile backdrop of trade wars and geopolitical uncertainty, the US housing market may be an unlikely stabilizing force. As goes the housing sector, so goes the economy. 2019 continues to be a year of rejuvenation for the single-family homebuilders after falling into a “mini-recession” in 2018. Sharply lower mortgage rates have eased affordability concerns.

Second-quarter earnings season may go down as the turning point for the largest US homebuilders. Order growth exceeded expectations, rising more than 6% from last year. Forward-looking metrics like mortgage demand, homebuilder sentiment, and commentary from homebuilders have painted a brighter picture for the second half of 2019 even as slower-reacting data sets like new and existing home sales have been slower to catch up.

Long-term fundamentals continue to support healthy and growing demand for single-family homes in the 2020s and upward pressure on home values amid a growing housing shortage and the demographic wave of millennials entering the housing markets during the next decade. Given that affordability - or lack thereof - remains a primary concern for the single-family ownership market, we see the build-to-rent segment as a key area of potential growth for the homebuilding sector.

Already the largest spending category for the average American, we see housing costs and rents continuing to rise as a share of total spending as a result of the growing housing shortage. At the investment level, we continue to see a long runway for growth in new residential housing construction - most of which will take place in the single-family sector over the next decade - in order to equalize the supply/demand imbalance. Until this imbalance is equalized, however, we expect continued upward pressure on housing costs and broader housing inflation, which already has been one of the lone drivers of inflation over the past decade.

housing inflation If you enjoyed this report, be sure to "Follow" our page to stay up-to-date on the latest developments in the housing and commercial real estate sectors. For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Homebuilders, Apartments, Student Housing, Single-Family Rentals, Manufactured Housing, Cell Towers, Healthcare, Industrial, Data Center, Malls, Net Lease, Apartments, Shopping Centers, Hotels, Office, Storage, Timber, and Real Estate Crowdfunding.

Disclosure: I am/we are long DHI, LEN, NVR, PHM, TOL, KBH, TMHC, MDC, MTH, TPH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.

Hoya Capital Real Estate advises an ETF. Real Estate and Housing Index definitions are available at www.HoyaCapital.com.